Casting a wider net

Read this article to understand:

• The significance of tech firms' dividend payouts
• How income investors can take advantage of long-term structural themes in the market
• How to best manage income portfolios in a higher-for-longer interest rates environment

In February, Meta, owner of Facebook and Instagram, celebrated its 20^th anniversary by announcing it would pay a dividend to shareholders for the first time. Later that month, another US tech giant, software firm Salesforce, followed suit. And in April, Google’s parent company Alphabet said it would pay its first dividend.¹

These announcements grabbed headlines amid growing interest in dividend-paying companies. Dividends from S&P 500 firms rose to $588 billion last year, up 22 per cent on the figure from 2020. Bank of America analysts say they expect 2024 to be another “banner year for dividends”, citing the importance of regular income in an environment of macro uncertainty. “The dividend is back”, declared The Economist in the wake of the Meta news.²

In truth, the dividend never went away. Indeed, many tech firms have been paying dividends for some time – including members of the “Magnificent Seven” group, such as Microsoft, Apple and Nvidia – as have companies in other sectors not usually associated with shareholder payouts, such as industrials.

By gaining exposure to these sectors, income investors can diversify their portfolios and potentially take advantage of long-term structural themes, such as the growth of generative artificial intelligence (AI), cloud computing and network infrastructure.

Casting a wider net in this way, rather than restricting allocations to more “traditional” income sectors, could be a particularly useful strategy in the current environment. While fears of a recession have abated and labour markets and consumption look strong, inflation is not yet fully under control. Central banks are expected to cut rates – but when, and by how much, are open to debate.

In this context, expanding coverage across geographies and sectors should allow investors to identify a broad spectrum of firms that show evidence of recurring revenues and resilient growth, and which could therefore potentially deliver sustained income and capital growth over the longer term. This can help protect capital and provide a hedge against inflation.

In this Q&A, Richard Saldanha, manager of the Aviva Investors Global Equity Income strategy, shares his views on Big Tech, the implications of the higher-for-longer interest rates, and how income investors can manage their portfolios most effectively in the current environment.

Meta, Salesforce and Alphabet have announced dividends for the first time in 2024. What does this mean for income investors?

This news obviously garnered a lot of attention. However, the reality is that it marks the development of a trend we have been watching for a long time.

The perception of dividend-paying companies is that they usually belong to mature industries with fewer growth prospects , such as telecoms or utilities. Meanwhile, high-growth tech companies have long had a reputation for focusing on other means of capital allocation, such as buybacks or mergers and acquisitions. But the reality is the likes of Microsoft and Apple have been paying dividends for years.

In 2019, S&P launched a new index, the Technology Dividend Aristocrats Index, to reflect the fact more and more tech companies were not only beginning to pay dividends, but also increasing their payouts.³ The companies in the index have tended to increase their dividends every year for at least seven years, through different economic environments and significant periods of recession (see Figure 1).

But while this is not an entirely new trend, the fact more tech companies are now entering the ranks of dividend payers is positive. Companies that announce dividends are making a firm commitment to shareholders that they are going to consistently deliver and grow their cashflows so they can support a dividend over time. And the presence of strong companies like Meta and Salesforce in the dividend-paying universe further broadens the opportunity set for equity investors with an income focus.

How do tech firms’ dividends compare with the broader market in terms of yield and dividend growth?

Though dividend yields are still not particularly high in the tech sector – Meta’s dividend equates to a forward yield of less than 0.5 per cent, for example – the prospects for dividend growth in these stocks is very attractive given that these firms’ cashflow growth is so strong (see Figure 2).

Exposure to tech firms also gives income investors the opportunity to participate in areas where we know there is a long runway for structural growth, notably generative artificial intelligence, but also cloud computing and digital payments.

You mentioned AI. What could be the wider implications of the generative AI boom and how are you playing the theme in your portfolio?

We invest in a range of companies that are linked to AI, not all of them in the tech sector. For example, some notable beneficiaries of AI are in the industrials sector. In fact, many industrials companies now have characteristics in common with technology companies, such as recurring revenues tied to software applications.

AI software adoption is rising rapidly, and large language models (LLM) and AI bots require massive computational power to process and analyse big datasets. High-end graphics processing units (GPUs), which are required for AI processes, generally need three-to-four times as much power as central processing units (CPUs). Thus, the demand for data centres is only set to grow as demand for data increases.

We are seeing “hyperscalers”, or cloud computing providers – namely Amazon, Microsoft and Google – continue to increase their investments into building these data centres. But this theme should also have implications for a number of industrial companies, which are not generally perceived as being driven by AI. Take Schneider Electric: around 20 per cent of its business and revenues come from data centres and it has recently said this part of its business is likely to grow in double digits for the foreseeable future.⁴

Other potentially overlooked beneficiaries of AI include suppliers of software and databases. These firms have proprietary datasets, which they supply to various end customers such as accountants, healthcare professionals or legal firms. The ability of LLMs to handle the vast amounts of data, but also boost the speed of decision making, is helping these companies improve the service they provide.

Turning from sectors to geographies, where do you see the best opportunities to hunt for dividends this year?

From a dividend growth perspective, the US continues to be the leading market and we have seen payouts grow among a number of the US-listed technology names we invest in. But there are attractive companies in other markets, which is why we believe a global approach is important.

From a yield standpoint, we find companies in Europe represent interesting opportunities and we are still seeing attractive dividends in that market. This is also true of some emerging markets in Asia.

There are also numerous great companies in the UK. Firms such as Unilever, the London Stock Exchange or RELX (information services) are industry leaders and have a global reach, which is important from a diversification standpoint. In our opinion, valuations of UK-listed companies also tend to be relatively more attractive than their US counterparts.

Last year was a challenging one for the “quality” companies usually targeted by income investors. How do you view that category now?

Two parts of the market that are prized for their quality and defensive characteristics, healthcare and consumer staples, were left behind in the Magnificent Seven-driven market rally in 2023. That created difficulties for many equity income investors. The situation was a point of contrast with 2022, when investors sought out these firms for their defensive characteristics amid the wider market drawdown.

But from our perspective, valuations in these sectors are looking particularly attractive now. While we have seen a relative re-rating in the market, we still see healthcare and consumer staples companies delivering resilient earnings and cashflows. In a world still characterised by macroeconomic and geopolitical uncertainty, we believe these companies have a lot to offer in equity portfolios.

Taking a step back to look at the macro picture, where do you see interest rates settle this year? And what would be the implications of a higher-for-longer environment for income investors?

Markets have been very quick to price in rate cuts. At the start of the year a total of seven cuts ­– around 170 basis points (bp) – were priced in for the US Federal Reserve (Fed). Until early February, investors were still expecting the first one to happen in March, but that expectation has been pushed back and there remains uncertainty as to the size and number of cuts we should expect in 2024.

Major central banks are still expected to cut rates this year, and this is good news for equities in general, just as the rate hikes in 2022 were a headwind for markets. However, we do not believe the battle against inflation is won and rates could well remain higher for longer. In our opinion, dividends are likely to remain the best defence against potentially sticky inflation.

For equity income investors, a focus on companies that are growing their dividends is essential. Though this applies in all market environments, it is even more important when inflation could be uncertain and, by definition, interest rates could be higher for longer. In the latter scenario, investors should look for companies with strong cashflow generation who can grow their dividends well above inflation. Casting the net wider to cover non-traditional income sectors can help in this respect.